Money Management

Debt Consolidation Loans Might Help, Could Hurt

If you're mired in debt, you might perk up when you hear about a loan that promises to:

Save you money by lumping all your debts into one loan with a lower interest rate.

Spare you payment hassles by providing the convenience of making one loan payment each month, instead of multiple payments to numerous creditors.

Would you jump at such an offer? Your first impulse may be an emphatic "Yes!" But hold on a minute.
A debt consolidation loan is one tool, among several, for gaining an upper hand over debt troubles. But before you commit to this type of loan, ask yourself a few crucial questions.

What will really change?

You could consolidate your debts into one loan in various ways, if you qualify. For instance, you could take out a home equity loan for the total amount you owe in credit cards and other consumer debt. You could put several credit card balances onto just one card with a lower rate. Or you could obtain a signature loan, unsecured by any collateral, to cover the total debt amount.
But, whatever the method, a debt consolidation loan often becomes "a Band-Aid," says Cynthia Campbell, certified financial counselor and assistant vice president of financial empowerment at Tinker Federal Credit Union in Oklahoma City. "Don't do one unless you address the behavior that caused your problems."
Campbell says she's read various studies showing that roughly 80% of borrowers who consolidate their debts end up repeating their mistakes. They revert to the same old spending patterns, and their debt woes "come back bigger and uglier," she says.

The people at your credit union might offer financial counseling services or refer you to a reputable agency.

"If you use your house as collateral, as in a home equity loan," Campbell says, "you're in a danger zone. You've taken unsecured debt and securitized it. And, yes, you're paying a much lower interest rate. But the place where your kids sleep at night is at stake because you might not change your behavior."

Can you afford the loan?

Let's say you're determined to mend your ways, and a debt consolidation loan is one option on the table. Examine it closely, experts advise.
"You may remove 19 monthly payments from your budget and replace them with one big payment. But if you go into this blindly, you may find out your budget can't afford that one big payment," says Dorothy Barrick, group manager and financial counselor at Greenpath Debt Solutions, a nationwide nonprofit organization based in Troy, Mich.
Another mistake people make, Barrick points out, is shifting 0% interest debt, such as hospital bills, into a debt consolidation loan. Those debts get lumped with others, perhaps even outrageously high-interest-rate debts such as payday loans. "People are willing to put everything into one consolidation loan," Barrick says, "just because they think life will be easier if they have one bill to pay instead of many."

Focus on the total you'll pay over the life of the consolidation loan.

But look at the interest rate difference between the individual debts and the consolidation loan, Barrick says. And handle any debt carrying 0% interest separately, she emphasizes, by working with the creditor directly.
Besides paying close attention to the interest rate and whether the loan payment fits into your monthly budget, focus on the total you'll pay over the life of the consolidation loan. "The term is key. In other words, for how long are you borrowing? That's the No. 1 thing to be cautious about," says Brian Benedict, senior vice president of lending services at Reliant Community Credit Union in Sodus, N.Y.
Say, for instance, that a borrower wants to consolidate credit card debts into a 15-year home equity loan or unsecured loan. "We counsel people about that all the time," Benedict says. "We advise them to remember the credit card was a five-year debt. If you string that out to 15 years, your monthly payment will drop, but you could end up paying as much or more in total payments. You want to calculate the total payment [for interest and principal] on whatever you're doing, not just the monthly payment."

Can you trust the lender?

A debt consolidation loan is still just that: a loan. A reputable lender will determine whether you can afford to pay it back before giving you such a loan. What's your debt-to-income ratio? How's your credit history? Such information will determine whether you qualify for a loan.

Credit union professionals care about you as a person and will give you a loan they think is good for you.

But, unfortunately, some lenders will give a loan to anybody just to make a buck. "They're looking for people who will pay high interest, with or without collateral," Barrick says. "We always recommend that people go to a credit union or small community bank. They care about you as a person and will give you a loan they think is good for you. If it's a lender that's only looking for profit, then it's customer beware."

What's your best move?

You have other options besides a debt consolidation loan. You could negotiate with your individual creditors to devise a solution satisfactory to both parties. You could work with a certified financial counselor who will help you create a plan to pay off your debts. Be sure you choose a nonprofit agency affiliated with the National Foundation for Credit Counseling, an umbrella organization based in Washington, D.C., with member agencies nationwide.
Your credit union may offer financial counseling services or be able to steer you to a reputable agency. Scams purporting to "help" people with debt woes are rampant these days, but they'll only take your money and leave you in more dire straits financially.
Your credit union is a good place to begin the journey back to financial fitness. Benedict, who's been in the lending business for 30 years, says, "People are looking to restructure their debt more than I've seen before." That may entail refinancing a mortgage or auto loan, or obtaining some type of debt consolidation loan, if appropriate. "The rates are great on all sorts of lending products," Benedict says. "Sit down with someone at your credit union to find out what you can or cannot do."